Investing in Innovation

Baird’s Near-Term Outlook for Biotech and Pharmaceuticals

October 29, 2010

For perspective on where Health Care companies – specifically Biotech and Pharmaceuticals – appear to be headed, it helps to understand where they’re coming from. While traditionally less economically susceptible, Biotech and Pharmaceutical companies and investors faced significant macro factors in 2010. The slow pace of the recovery and unfavorable exchange rates obviously presented challenges for companies in all sectors. Health care reform was a roller-coaster ride early in the year, and sovereign debt caused quite a bit of consternation, particularly in countries like Greece and Spain, where austerity measures impacted prescription drug prices and reimbursement policies.

The good news is that, as of the end of the third quarter, bigger biotech and pharmaceutical companies appear to be meeting these challenges. The key question then becomes, “What will the future bring?”

Reform RepercussionsQuantifying the impact of health care reform was obviously important for companies and investors in 2010, particularly regarding the increased rebate now applicable to Medicaid-related business. Those impacts ranged from less than 1% to as much as 3%. Second-quarter reports offered greater visibility, helping investors see that the impact was in line with original estimates and, in some cases, even a little bit less. Looking ahead to 2011, investors will be assessing the impact of closing the Medicare Part D gap in drug coverage – called the “donut hole” – as well as the new excise tax on the industry. Most companies have yet to release estimates of the incremental impact in 2011.

On Research and RegulationResearch and innovation are the lifeblood of the industry and will only continue to increase in importance as Pharmaceuticals focus on core competencies such as commercialization, late-stage development and the regulatory approval piece. Investors may have expected more M&A in 2010, but the industry was still digesting several large mergers from 2009. There also seems to be a lower risk tolerance, with Pharmaceutical companies preferring to wait until available assets are de-risked before paying up. The pipeline for Pharmaceuticals should remain dominated by biotech companies targeting high unmet medical needs, specialty or orphan areas, as well as those developing higher-barrier biologic products. Big Pharma currently has well over $100B in cash on their balance sheets to shop with.

Meanwhile, the conventional wisdom is that it has become harder to get new drugs approved. This is true if you go back to the early 2000s. But, if you reset to the post-VIOXX® era and the new regulatory paradigm, the trends are not so discouraging. By the third quarter of 2010, the industry was on pace to secure approval for more than 20 new drugs, similar to 2008 and 2009. Most drugs now up for approval fall into two broad categories. Drugs addressing diseases with no current treatment or that offer a major improvement in the treatment paradigm are generally evaluated using the FDA’s traditional risk/benefit equation. Conversely, “me-too” drugs targeting areas where other treatments exist usually find any hint of a safety concern can easily derail the approval process. Baird generally recommends avoiding investments in “me-too” drugs.

Trends and OpportunitiesBaird believes Hepatitis C research and treatment will undergo a major paradigm change with the introduction of the first oral, direct-acting antiviral drugs in 2011 from Vertex Pharmaceuticals Incorporated (VRTX) and Merck (MRK). This could represent a multi-billion dollar per year opportunity through 2014, after which we expect Hepatitis C treatments to evolve again along the lines of HIV treatments as novel combinations of direct-acting antiviral drugs come to market. Field checks with opinion-leading physicians have remained consistently positive on the profile of Vertex’s telaprevir for about two years now. Baird is also watching Incyte’s (INCY) compound ‘424, a treatment for bone marrow diseases such as myelofibrosis. Because it will have an orphan disease area to itself for a while, this could translate into a $1 billion-plus opportunity. Diligence with doctors closest to the development of the ‘424 compound reinforces Baird’s expectation that two pivotal trials, slated for completion between this December and next June, have a very high probability of success.

Investment InsightsWhile risk aversion seemed to be the mantra of most investors for much of the first half of 2010, the appetite for greater risk (and the possibility of greater rewards) seemed to return in the third quarter.

Biotech and Pharmaceuticals investors with lower risk profiles generally prefer commercial-stage companies, which usually go hand-in-hand with larger market capitalizations. Going forward, such companies may face continued exposure to the macroeconomic headwinds already mentioned, and, because they are past the most risky stages in their growth, will generally have less exciting upside. For more risk-tolerant investors, the exciting stories with better upside will generally be found in the smaller and emerging mid-cap spaces. These investments almost always carry higher risk, and investors should make sure the companies have strong cash positions or access to cash. The macro pressures these companies may face down the road are dwarfed in comparison to the key clinical and regulatory catalysts now, making them, in some ways, more attractive in the current environment.